Market Commentary – Q1 2021
Market Commentary – Q1 2021
One Year Later, Markets Have Recovered - What Might be Next?
After posting positive results for the first quarter in 2021, major stock indices, on average, have been positive over the past four quarters. So far in 2021, small stocks have outperformed large stocks, value stocks have outperformed growth stocks and US stocks have outperformed international stocks (see chart below).
A lifting of election uncertainty, prospects for fiscal stimulus from Washington, an ultra-accommodative Federal Reserve, and news about vaccine developments sent stocks soaring through the highs set in February 2020. At this juncture, after such great returns following the Covid sell-off, our thoughts turn to those catalysts that could propel stocks higher going forward. These catalysts are not only important for higher stock prices, they are also necessary to justify elevated stock market valuations and hopefully avoid a stock market sell-off. The next section discusses just a few of the many indicators we are watching to gauge potential future economic conditions.
Global and US Economy
Global Purchasing Manager’s Index (PMI)
We often feature results from a global survey of hundreds of large multinational manufacturers. This survey is called the Purchasing Manager’s Index and its results are updated monthly. The sum of the survey is to determine if conditions in the manufacturing sector are improving or deteriorating from the prior month’s survey. Manufacturers are often considered the frontline of an economy (meaning they feel the pressures of wage increases, increase in cost of materials, new orders, etc. first before other industries). A reading above 50 reflects expansion in manufacturing and is considered a good sign for a country’s economy. In the graph below, green reflects expansion and red shows contraction. The graph shows that most of the world is in expansion mode.
What may be even more telling than current levels are the quarterly rates of change for key countries (below). Rate of change is important to watch for slowdowns in manufacturing, as this could be a sign of slowing future economic conditions. Most countries are expanding in the manufacturing sector, a positive sign for future global economic growth.
The Conference Board produces a survey of US-based CEOs’ perceptions of current and expected business and industry conditions. The most recent survey yielded a reading of 73, which was up from the last reading of 64. This marks the highest level of CEO confidence since the first quarter of 2004!
Rising business confidence has historically been a good sign for the economy and corporate profits. Improving confidence can often translate into more employment, wages, and capital expenditures. Here are some key details from the last report from The Conference Board:
Consumer Sentiment (Confidence)
One cannot write about the US economy and outlook without talking about the main driving force — the consumer. As vaccine dissemination spreads to a younger population, assuming more people choose to be vaccinated, consumers and governments will continue to feel more comfortable with social activities (e.g., going to restaurants, sporting events, and traveling). The ‘service’ side of the economy was severely impacted during the pandemic but is starting to show signs of life. Consumer sentiment has reached a new high since the pandemic began, a good sign for the economy and future spending.
The weight of economic evidence is just one component when assessing the current market environment. Often, if robust economic growth is expected in the future, the stock market will reflect this optimism. Therefore, stocks are considered ‘forward looking.’ Confirming these signals by analyzing underlying market strength can provide some comfort in a market at all-time highs.
Last year’s headlines and performance (at least through August) were dominated by FANMAG (an acronym for Facebook, Apple, Netflix, Microsoft, Amazon, and Google) stocks. However, when market leadership is being driven by just a handful of companies, we consider the market leadership to be narrow. Narrow markets tend to make many investors a bit more cautious than an advancing market with widespread sector (and company) participation. In the graphic below, the blue line is FANMAG and the green line is the S&P 500 Index return minus the FANMAG stocks.
We view a broad-based move in stock performance with less skepticism. A broad-based move basically means many stocks are moving higher with increasing momentum. This is often a sign that stocks are making new highs based on fundamental factors, and broad-based moves have been tied to stronger, more sustainable market advancements in past cycles. Since September, the broader market has significantly outperformed the FANMAG stocks. The participation of additional sectors is a signal that market participants may be looking towards the re-opening as a source of more rapid growth for other economic sectors beyond the technology sector.
Risks to Stock Market Outlook
Historically, ownership in common stocks has been one of the best, most liquid ways to grow wealth over time. However, stock ownership does not come without risk. For a diversified investor, risk is typically defined as volatility, and over a short-time horizon, stocks can be very volatile. If stocks are trading at expensive levels, like they are today, the stock market can be vulnerable to bad news. Potential headwinds that we are on watch for include higher corporate taxes and lowering of profit expectations due to higher input price inflation.
Most investors today have never experienced a bear market for bonds. In risk-adjusted terms, bonds have performed very well since the early 1980’s. Bonds can be particularly sensitive to interest rate fluctuations as bond prices have an inverse relationship with interest rates. Interest rate risk is the risk of a bond price decreasing when interest rates increase. With interest rates at a historically low levels, investors with a capital preservation investment objective will need to be cautious with their bond portfolios to offset interest rate risk.
In the above example, since September 1981 (the interest rate peak), long-term Treasury bonds returned 9.5% per year. In the years with increasing interest rates, long-term Treasury bonds returned only 2% per year.
Based on many common valuation metrics, such as price-to-sales and price-to-earnings ratios, a portion of the recent good news may be largely priced in. However, despite the lofty valuations and risks associated, we believe the catalysts are in place to continue to push markets even higher. Fiscal stimulus, monetary stimulus, increased consumer spending, and capital expenditures from large corporations all appear likely to remain favorable for the equity markets over the next several months or more.
The opportunity set in international and emerging markets stocks appears to be relatively attractive due to the inevitability of higher corporate taxes and an expensive stock market in the US. In recent months, we have been increasing exposure to Emerging Markets stocks. Also, not all stocks in the US are overly expensive. Accordingly, we reduced ‘growth’ style stocks to favor ‘value’ style stocks due to attractive valuations and future earnings potential as the world emerges from the pandemic.
As stated in the bond section above, we are preparing fixed income portfolios to minimize the impact of a long-term rising interest rate environment. The most recent change we made was a reduction in the interest rate sensitivity by reducing intermediate-term bonds. Short-term bonds are typically less sensitive to rising interest rates. Additionally, bonds that offer higher yields can also help with reducing interest rate sensitivity, and we have added exposure to this area of the bond market as well. Higher yielding bonds are often riskier, so we are making sure to keep a very prudent balance of high-quality bonds with high-yield bonds to ensure fixed income portfolios also fulfill capital preservation objectives.
If you have any questions regarding the changes discussed in the ‘Investment Strategy’ section, please reach out to your wealth advisor. Thank you for your trust and confidence in navigating the ever- changing market environment.